Cabot Turnaround Letter Issue: November 30, 2022

Tax-Loss Selling – Two Ways to Harvest Lemons

For most investors, 2022 has been a year to put in the past. From bonds to stocks to cryptocurrencies and most commodities, losses are everywhere. The urge to leave this all behind is powerful.

But, before the calendar turns, investors have at least two ways to turn the year’s losses into assets.

The first is for taxable investors to sell their losers to generate capital losses. These losses can be used to offset other capital gains, helping to reduce tax bills. In a year when many investors sold long-time winners with large embedded profits, which can be taxed at rates as high as 20% at the federal level alone, selling losers can potentially shield some or all of these profits from taxes. Shorter-term losses, for positions held for less than a year, can also be netted against gains. If losses taken exceed gains taken, they can be used to offset up to $3,000 of ordinary income, making losses a valuable asset, particularly for investors who may face combined federal and state tax rates reaching well into the 40% range. Also, realized losses that aren’t used in one year can be carried forward to future years. Investors wanting to maintain a position in a particular ETF or stock need to avoid getting tripped up by the 30-day wash sale rule which can invalidate the tax benefits of a capital loss. Surprisingly, cryptocurrency losses aren’t yet subject to the 30-day wash sale rule. Investors should consult with their qualified tax advisor before making any tax-related trades to help ensure proper tax treatment.

Another way to capitalize on losers is by buying beaten-down shares that other investors are selling. While we at the Cabot Turnaround Letter have an intense focus on long-term business fundamentals and underlying valuations, even we are tempted by worthy short-term bargains created by artificial year-end selling pressure such as tax-loss selling.

Tax-motivated selling comes not only from taxable advisor-managed and personal accounts, but also from mutual funds. These funds distribute their capital gains around year’s end, but managers would rather avoid hitting investors with these taxable events.

Year’s end brings two other sources of artificial selling pressure. The first is window dressing by professional investors. These managers want to avoid showing their clients and consultants that they held losers, so they sell these stocks to keep them out of year-end reports. This is particularly true in a year when many managers held previously touted stocks that went on to produce embarrassing and large losses. These managers have a strong career-driven motivation to sell these losers at any price.

Similarly, managers tend to chase performance as the year’s end approaches in order to maximize their performance-based annual bonuses. This means selling off losers before they go down any further.

A third source is behavioral. Investors of all types tend to want to start the new year with a fresh perspective – so loser stocks are offloaded without regard to price.

Once the selling pressure fades around year’s end, many of the worst performing stocks bounce upwards, sometimes sharply. Nimble investors can capture some of the bounce before longer-term fundamentals return as primary drivers in late January or so.

Discussed below are seven stocks that look most capable of a bounce. For several, the valuations are higher than we would typically want to see, but with this type of trade, valuation is less important.

A few overly sold Cabot Turnaround Letter stocks, like Kaman (KAMN), Xerox (XRX) and Vodafone (VOD), may also experience year-end selling but also have bounce potential, and more. If you have not yet taken a position in these stocks, or would like to add them, this could be a good time to do so.

Amazon.com (AMZN) – Amazon’s online retail business was among the biggest beneficiaries of the pandemic, as nearly all shopping was driven away from physical stores. Less known is Amazon Web Services, or AWS, which co-dominates the cloud computing industry with Microsoft. While both of these businesses may seem to have boundless growth, their prospects have visibly slipped. Consumers are returning to physical stores and incrementally migrating to other online retailers, while AWS’ growth is slowing as the industry marches toward maturity and customers slow their tech spending. Even advertising revenue growth is slowing, and investors are having second thoughts about the value of the Amazon Prime video streaming service. AWS growth is critical to the Amazon story as this segment generates more than 100% of total company profits. With these headwinds, it is perhaps not surprising that Amazon’s shares have tumbled 50% in the past year.

Using very rough math and some assumptions about trading volumes and other inputs, investors have incurred as much as $900 billion in losses in Amazon shares. The stock’s slide has accelerated recently, suggesting that investors are bailing, likely spurred on by tax-loss selling and other artificial selling pressures. But, the company should readily maintain its lead in the cloud computing industry and return to solid growth when the current tech down cycle recovers. Helpfully, Amazon is acting like a well-run company in that it has a non-founder as its CEO and it is accepting that cost-cutting is necessary. All of these traits make Amazon stock a prime candidate for a new year bounce. We almost included this stock in our 13F section, below, given the notable activity and positions held by highly regarded long-term value investors like Dodge & Cox, Capital Research and Wellington Management.

Match Group (MTCH) – Match pioneered online dating and today is one of the largest such companies in the world. Its 13 brands serve over 10 million subscribers across a wide range of demographics and languages. Formerly part of Barry Diller’s legendary IAC/Interactive Corp, Match has been a fully independent company since June 2020. The shares have tumbled 72% from their peak as the strong dollar, macro-economic headwinds and some likely post-pandemic normalizing have slowed previously strong revenue and profit growth. However, the shares could readily rebound as expectations appear too low: excluding currency effects revenues grew 10% in the most recent quarter, other key revenue metrics were favorable, profit margins remain stable and high, and new product-level leadership is revitalizing core offerings. Management also provided encouraging guidance for next year. These washed-out shares could bounce sharply over the next month or two.

Medtronic plc (MDT) – While officially domiciled in Ireland, Medtronic is an American company (based in Minnesota) that specializes in producing medical devices for cardiovascular, gastrointestinal, spinal and other treatments as well as insulin pumps. Once a successful growth company, Medtronic is struggling with slow demand, an uninspiring new product pipeline, higher competition and reimbursement-related pricing pressure across most of its product line. Recent results were disappointing, weighed down by foreign currency issues, regulatory delays, hospital staffing shortages and Chinese pricing changes, leading to more selling of its shares. Year to date, the stock has tumbled by over 40% and shares have slid to their 2015 price level. However, Medtronic has strong market shares in its core products, and customer retention is high as doctors are unwilling to switch to competitors to save a few dollars. The company’s diverse range of products helps limit risks from any single product. Profits remain robust and Medtronic carries a relatively modest debt load. A new CEO since 2020 is tilting the company toward more growth and smarter capital allocation. Trading at only 13x EBITDA and 14.8x per share earnings, the shares could be poised for at least a healthy new year bounce.

Meta Platforms (META) – The Facebook franchise, clearly the icon of the 2010s social media culture, is past its prime. Those younger than 38-year-old CEO Mark Zuckerberg have migrated to better platforms, followed by advertisers, and Apple’s new privacy features have further crippled Facebook’s revenue stream. Zuckerberg’s insistence on spending heavily to develop a metaverse is draining the company’s valuable free cash flow. Few if any professional investors want to be seen holding these shares, now down an embarrassing 70% and which have underperformed ExxonMobil over the past six years. Yet, once the calendar turns, sentiment may shift, at least temporarily. At only 14x per share earnings and 5.8x EBITDA based on estimated 2023 results, Meta shares have little risk of further valuation compression. And activist investors are starting to exert pressure on Zuckerberg to relent on his metaverse build-out. Overall operating expenses may come down as he has already started a sizeable layoff program. While the long-term future of Meta is cloudy, the shares look primed for a near-term burst.

Paramount Global (PARA) – Previously named ViacomCBS, Paramount is a global media and entertainment company that owns the Paramount Pictures TV and movie studios, Nickelodeon, Showtime, the CBS television network, Comedy Central and a vast library of other brands and films. Its struggles with weak advertising revenues, incremental secular erosion of cable television fees and the costs of developing a streaming service have driven its shares down 70% in the past five years. The steady and large share price declines, including missing out on the recent market surge, make it an interesting bounce candidate. Also, its relatively tiny $13 billion market cap and reasonable debt load, combined with its low 8.3x EBITDA multiple, may make it an enticing takeover target. Not hurting the shares’ merits is the presence of Berkshire Hathaway as the largest shareholder with a 14% stake. Investors may find that these traits add up to an attractive picture for Paramount Global shares.

RH (RH) – Formerly known as Restoration Hardware, this well-known retailer caters to high-end consumers looking for luxury furniture and related home goods. RH has demonstrated its ability to remain relevant and aspirational to this generally recession-resistant demographic, helping provide a more stable long-term revenue and profit profile, even as its near-term prospects have suffered from the slowdown in the housing market. Its 50% gross margins, which are comparable to only a few other elite brands, are partly buttressed by its membership model that generates as much as $80 million in annual fees. While RH’s plans to extend its brand into Europe, hotels, luxury yachts and other channels may or may not succeed, and many investors have fled the shares (reflected by the 60% price collapse), the company has the confidence of Warren Buffett, whose Berkshire Hathaway recently raised its stake to 10% of RH’s shares.

The Walt Disney Company (DIS) – Investors can hardly sell the shares of this iconic company fast enough. Since their pandemic peak in March 2021, Disney’s shares have tumbled 52% and now trade in line with their early 2015 price. Several strategic, tactical and cultural missteps under the now-former CEO, along with the ill-timed arrival of the pandemic, growing losses in the Disney+ streaming platform, and conflicts with the not-quite-full-exit of past and once-again current CEO Bob Iger, have plagued the company’s performance and its perception by investors. But Disney remains highly profitable, seems poised to continue to grow, holds some of the world’s most valuable brands and properties and has a sturdy balance sheet. The valuation isn’t a glaring bargain at 23x estimated fiscal 2023 per-share earnings, but investors will likely look through this to a brighter future than the aggressively sold shares currently imply.

Closing prices on November 25, 2022.
* EV/EBITDA is Enterprise value to Earnings before interest, taxes, depreciation and amortization. EBITDA is a proxy for cash operating earnings. Valuations based on calendar years ending in December 2023 except for MDT which ends in April 2023, RH which ends in January 2024 and DIS which ends in September 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Attractive Stocks from the Recent 13F Filings

In what is becoming a recurring quarterly feature, we are including in this issue our review of 13F reports. Within 45 days of the end of every calendar quarter (November 15 is the most recent filing deadline), institutional investors overseeing at least $100 million in assets are required to report all of their holdings to the U.S. Securities and Exchange Commission. These reports are publicly available and provide a window into who holds what stocks.

We’ve found these reports to be among our more productive idea-generating tools. We start our search by concentrating only on highly regarded managers that share our long-term value/contrarian approach – over the years we’ve developed a core roster of about 30 managers, with another 50 or so on our evolving secondary list. We then troll through their reported holdings, looking for large positions that have recently been increased, smaller positions that have had sizeable increases, or new names that were started at meaningful sizes. These traits indicate that the manager has conviction in the stocks. We add another step that adjusts for the reality that the report shows positions with at least a 45-day lag and may no longer be high-conviction ideas.

Next, using our standard analytical funnel, we cull the list to only those that meet our rigorous investment criteria. We discuss below four stocks that this process produced from the November 15 batch of 13F reports. We also note that General Electric (GE), Warner Bros Discovery (WBD) and Capital One Financial (COF) are held by several of our most closely related funds including Dodge & Cox, Baupost Group and Pzena Investment Management.

Closing prices on November 25, 2022.
* EV/EBITDA is Enterprise value to Earnings before interest, taxes, depreciation and amortization. EBITDA is a proxy for cash operating earnings. Valuations based on calendar years ending in December 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Celanese Corporation (CE) – Celanese produces specialty and intermediate chemicals that are inputs into thousands of everyday products. It is also a major producer of specialized fibers for cigarette filters. Acquired by Blackstone in 2004, Celanese returned to public ownership in 2005, leading to a 9x gain in the shares through early 2022. However, investor concerns about a recession and pricing/volume pressures have driven the shares down by 40%. Another worry is Celanese’s recently completed acquisition of DuPont’s Mobility and Materials business for $11 billion in cash – while this deal makes sense, it adds considerable debt to the company’s balance sheet. Overall, Celanese is well-managed, has a valuable niche in the global chemicals industry and produces generous free cash flow. Its valuation, at 4.7x estimated 2023 EBITDA, which includes merger synergies, provides a sizeable margin for safety. Highly regarded Turtle Creek Asset Management, a disciplined long-term value investor, recently initiated a new position in Celanese shares at 2.25% of its total assets – an impressive vote of confidence.

Colgate-Palmolive Company (CL) – Colgate is a great example of a high-quality company that seems poised for a break-up. Its toothpaste, lotions and household cleaners almost define the term “staples” given their core role in nearly every home in the developed world and increasingly in those in emerging markets. And, the Hill’s Pet Nutrition business, which accounts for about 20% of total sales, has provided strong growth since its overhaul in 2018. However, with intensified competition in the pet food segment and slowing growth in the non-pet segments, and with pricing power hiding slow or negative volume growth, investors are doubting the merits of Colgate’s strategy. Activist investor Third Point has recently taken a 1.4% stake, as it sees the potential for an independent Hill’s to be worth as much as $20 billion, or nearly a third of all of Colgate. Colgate trades at a not-cheap 24x estimated 2023 earnings, but its shares have gone nowhere in six years even has the S&P 500 has nearly doubled. The company has an under-levered balance sheet and pays a respectable 2.4% dividend yield.

New York Times (NYT) – A change in leadership at this company several years ago successfully shifted its strategy to become more digital and more politically relevant, which led to impressive share price gains. However, slowing revenue and profit growth have driven the shares down nearly 50% from their 2021 peak, although a recent bounce has partly offset this decline. Noted activist investor Value Act reported raising its large position by another 8% in its most recent 13F filing. While the Ochs-Sulzberger family controls the company, enough outside pressure, especially through behind-the-scenes efforts of ValueAct, could unlock value in this iconic company through more aggressive marketing, among other possible changes. While the valuation remains challenging, it is not unreasonable for a company with a high-quality business model (nearly 9 million digital-only subscribers, and a healthy 66% of total revenues generated from subscriptions), healthy profit margins (14%) and a debt-free balance sheet.

SS&C Technologies Holdings (SSNC) – This not-well-known company is the world’s largest hedge fund and private equity fund administrator and is the world’s largest mutual fund transfer agent. It also is a major provider of healthcare information technology. Its software drives front- and back-office operations across the entire range of capabilities from accounting to risk analytics to regulatory reporting. After a fundamental- and momentum-driven 10x run from 2012 to 2021, the shares have been cut by nearly 40% as investors worry about slowing growth in its core customer base. However, the company has a strong market position, has high customer loyalty, and produces wide 40% profit margins, indicating a solid recurring profit stream. One knock is that its wide margins are due to its low R&D spending, as it mostly acquires its technologies rather than develops them in-house. The balance sheet is healthy although not modestly levered and the valuation is inexpensive at 9.4x estimated EBITDA. Several notable deep value investors, like Pzena Investment Management and Baupost Group, have meaningful positions in SS&C.

RECOMMENDATIONS

Purchase Recommendation: Six Flags Entertainment (SIX)

Six Flags Entertainment (SIX) 1000 Ballpark Way Suite 400 Arlington, Texas 76011 www.sixflags.com

Symbol: SIX Market Cap: $1.9 billion Category: Mid Cap Business: Theme Parks Revenues (2022e): $1.4 Billion Earnings (2022e): $113 Million 11/25/22 Price: 22.6 52-Week Range: 16.83-47.24 Dividend Yield: 0% Price target: 35

Background: Six Flags Entertainment is one of the world’s largest theme park operators, with 27 parks across the United States, Mexico and Canada. Founded in Texas in the early 1960s, the company has expanded by acquiring existing parks and, to a lesser extent, by opening new parks. Ownership of Six Flags has changed hands several times: Pennsylvania Railroad, Time Warner and Premier Parks were once owners. Excessive debt under Premier Parks led to Six Flags’ bankruptcy in 2009. It emerged the next year with an improved balance sheet and new leadership. In the following decade, the shares surged 600%, driven by impressive revenue and earnings growth.

However, since mid-2018, the shares have collapsed 70% as growth stalled, overseas initiatives in China and elsewhere failed and the devastating effects of the pandemic led to deep operational disruptions. Frustration with the strategy and results led to a complete changeover in the board of directors starting in January 2020 and senior leadership starting in November 2021.

Today, the company is implementing its new strategy. A major issue has been heavy use by teenagers who pay little while crowding the parks and creating a family-unfriendly atmosphere. The new strategy includes investing in rides, improving maintenance, upgrading the food and beverage offerings and generally improving the guest experience to attract more families. A key component of this new strategy is raising ticket prices significantly. Some parts of the strategy are working: total guest spending, including tickets and in-park food, beverage and other purchases, is increasing sharply. One part, however, is clearly falling short: attendance in the most recent quarter was down 33% from a year ago. With total sales falling 21%, even the heavy cutting of excessive costs couldn’t salvage profits, which fell 20%. The turnaround is taking much longer than management and investors anticipated, with a difficult labor environment, high gasoline prices and other consumer pressures likely to weigh further on the pace and odds of success. The shares trade at about 50% of their YTD high price, implying that only the most intrepid turnaround investors remain on board.

Analysis: This turnaround offers what appears to be an asymmetric payoff. The sharp sell-off has left the shares pricing in a dour future, with perhaps 36% downside and potentially 100% upside in reasonable turnaround scenarios.

The downside is supported by resilient demand for Six Flags’ parks. Earlier this year, its attendance returned to the pre-pandemic 2019 level and annual attendance is generally stable at around 30 million guests. Cash operating profits run about $500 million in a difficult year, so that profit level appears likely to be a floor. If the turnaround strategy fails, we think a reasonable downside, based on these and other conservative assumptions, is about 36% for SIX shares.

The upside is driven by the potential rewards of success. The new CEO, Selim Bassoul, previously led Middleby Corporation during an 18-year stretch which produced an 80-fold increase in that company’s shares. While producing commercial grade kitchen gear is quite different from operating consumer theme parks, Bassoul’s intense focus on customer demand traits, thin bureaucracy and full accountability should eventually produce meaningful improvements in profits. Based on the reasonable potential for $600 million in EBITDA, an increase in the multiple to 10x and some incremental cash accumulation, the shares could return to the mid-$40 range, about 100% above the current price yet still well below the prior high.

While the most recent quarter’s results may have alarmed investors, we see this entire year as on-the-job training for the new CEO. One early mistake was raising prices too aggressively and using a too-complicated pricing menu, which pushed customers away. No doubt other mistakes were made as well. Over the winter, the leadership team will certainly assess and adjust its strategy for the 2023 season.

Six Flags generates considerable free cash flow – likely to be about $150 million in a weakened 2023. This cash surplus provides financial flexibility and should help reduce the company’s elevated $2.4 billion in debt (about 5x EBITDA). And, only $110 million of its debt is due before April 2024, buying the company time for its turnaround to gain traction. Respected investor H Partners recently raised its stake to nearly 20%. The firm is a long-time shareholder and provides valuable shareholder-oriented oversight to keep management properly focused.

With low expectations, low share valuation, a solid asset base and a capable leadership team working to turn around the company’s prospects, shares of Six Flags look highly attractive. Our price target is conservative, allowing us an opportunity to gauge the turnaround’s prospects before potentially committing to waiting for the full upside potential.

We recommend the purchase of Six Flags Entertainment (SIX) shares with a 35 price target.

Ratings Changes

On November 22, we moved shares of long-recommended Shell plc (SHEL) from Buy to Sell. Our call is part of our effort to reduce the number of names on our recommended list to focus only on the most attractive turnarounds. As the shares had only 6% upside to our 60 price target, this rating change to Sell was relatively straightforward.

Shell is well positioned in the global energy industry and currently generates impressive free cash flow. The company is returning much of this free cash flow to shareholders, through dividends and share buybacks, following a substantial reduction in its debt burden. However, Shell’s incoming leadership is likely to remain committed to investing heavily in new sources of energy, including wind, hydrogen and a broad range of renewables as well as carbon capture and other climate-friendly programs. Its new initiatives will likely be driven by both internal investments and acquisitions/partnerships.

The company may be successful in generating attractive returns from its transition to new energy sources and would clearly benefit from increases in oil and natural gas prices. But, even as the valuation is underwhelming, we find that the shares’ risk/return trade-off is not favorable enough to justify holding the position. In essence, it is not a turnaround worthy of new money.

Since our initial recommendation in January 2015, the shares have generated a 16% total return.

Performance

The following tables show the performance of all our currently active recommendations and recently closed out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion – $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:

1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
3. SP – Given the unusually high risk, we consider these shares to be speculative.
4. * Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.

The next Cabot Turnaround Letter will be published on December 28, 2022.